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Fin 4201/8001 3 Business tenets Three basic characteristics of the business itself. Is the business simple and understandable? Does the business have a consistent operating history? Does the business have favorable long-term prospects?

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Fin 4201/8001 7 Characteristics of Franchises A company providing a product or service that is needed or desired, has no close substitutes, and is not regulated. These characteristics gives Pricing flexibility Economic goodwill

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Fin 4201/8001 8 Characteristics of Commodities Product or service that is virtually indistinguishable from the competitor, and generally a low-returning business.

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Fin 4201/8001 10 Management Tenets Three important qualities that senior managers must display. Is management rational? Is management candid with its shareholders? Does management resist the institutional imperative?

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Fin 4201/8001 11 #4 – Rationality Rationality in What to do with earnings? Distribute, or Retain/invest. Depends on life-cycle of the company. development -> rapid growth -> maturity -> decline

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Fin 4201/8001 15 Three problems with managers behavior Lust for hyperactivity. Continuous comparison with peers. Exaggerated sense of their own management capabilities.

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Fin 4201/8001 16 Financial Tenets Four critical financial decisions that the company must maintain. Focus on ROE, not on EPS Calculate “owner earnings.” Look for companies with high profit margins. One dollar premise.

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Fin 4201/8001 18 On leverage Use of leverage to increase earnings makes company vulnerable during bad times. Borrow when it is cheap rather than when you need it. Debatable. His argument: “If you want to shoot rare, fast- moving elephants, you should always carry a gun.”

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Fin 4201/8001 21 #10 – The One-Dollar Premise One dollar of retained earnings should lead to one dollar increase in shareholders’ wealth.

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Fin 4201/8001 22 Market (Stock market) Tenets Two interrelated cost guidelines. What is the value of the business? Can the business be purchased at a significant discount to the value?

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Fin 4201/8001 23 #11 – Determine the Value of the Business Discount future “owners earnings” by an appropriate discount rate. Buffett looks for companies with predictable earnings and then discounts them with risk- free (30 yr. T-bond) rate.

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Fin 4201/8001 24 #12 – Buy at Attractive Prices Buy when the price is well below the value. The higher the discount, the higher the margin of safety. “The market, like the Lord, helps those who help themselves. But unlike the Lord, the market does not forgive those who know not what they do.”

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Fin 4201/8001 25 Case Study: The Coca-Cola Company Coke was first sold in the United States in 1886, now sells in nearly 200 countries. Buffett started buying Coke shares in 1988 and by 1989 had accumulated almost 7 percent of the shares.

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Fin 4201/8001 26 Our objective Try to understand how he evaluated and made the investment decision, on the basis of his tenets.

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Fin 4201/8001 27 Tenet: Simple and Understandable Sells syrup to bottlers. What could be simpler? More than 200 beverages including soft drinks, juices, tea etc.. 68% of profits and 62% of sales come from overseas operations.

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Fin 4201/8001 28 Tenet: A consistent Operating History Consistent increase in Per capital consumption in US since 1880’s. Increasing per capital consumption worldwide. Profits without substantial capital expenditure.

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Fin 4201/8001 33 Tenet: Candid Management Goizueta had put all the focus on increasing shareholders’s wealth. He communicated honestly and candidly with shareholders through annual reports. Words were put into action and Coke sold unrelated businesses and focussed on selling syrup.

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Fin 4201/8001 34 Tenet: Rational Management Increased dividend rate by 10% per year during 1980s. But was able to retain more because of much higher growth in earnings. Repurchased more than 1 billion shares.

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Fin 4201/8001 43 With 17.8% growth from 1980 -87 Value = 828 / (0.9 -17.8). Can’t do that. So let’s do a two stage. Assume Coke grows at an annual rate of 15% for the next ten years and then settles down to a annual growth rate of 5%.